What You Can Invest In
Covered Warrants
- Introduction
- The exercise price and the market value of the underlying security
- Expiry and the passage of time
- Volatility
- Dividends
- Interest Rates
- Conclusion
Introduction
The price of a warrant is made up of two components, known as the intrinsic and the time value of the warrant.
The intrinsic value of a warrant is sometimes referred to as the minimum value of the warrant and is calculated in the following manner:
- For a call warrant:
Intrinsic value = Underlying security's price - Exercise Price of the warrant (but cannot be negative). - For a put warrant:
Intrinsic value = Exercise Price of the warrant - Underlying security's price (but cannot be negative)
Warrants are said to be out-of-the-money, at-the-money or in-the-money according to whether they have intrinsic value. If a negative value is obtained when the above formula is applied, the warrant in question is said to have no intrinsic value and is termed "out-of-the-money".
If the underlying security is trading at the exercise price of the warrant, the warrant is said to be "at-the-money".
If a positive value is obtained from the intrinsic value, the warrant is said to be "in-the-money". - For a call/put warrant:
However, warrants which have no intrinsic value will usually be worth something on market prior to expiry. This is the time value component of the warrant's price and is calculated as follows:
Time value = Market price of the warrant - Intrinsic value.
This time value component takes into account the factors described in this chapter and represents the price paid for the possibility that the warrant will finish either in-the-money or more deeply so. Obviously, this possibility decreases with the passage of time and so warrants' time value is eroded. This phenomenon is known as "time decay" and accelerates as the warrant nears expiry.
Hence, the time value of a warrant corresponds to the level of probability that it will finish in-the-money or more deeply so -i.e."highly likely", "possible", "improbable". Contrary to a classic long position in the underlying security, where returns are made when the security moves in the anticipated direction, profitable warrant investment involves being right on two accounts: the direction of movement in the value of the underlying security and the timing of this move. These aspects are taken into account when determining the price of a warrant.
The exercise price and the market value of the underlying security
The market value of a warrant at expiry should equal its intrinsic value. In general,the value of a call warrant will increase as the price of the underlying security increases and the value of a put warrant will increase as the price of the underlying security decreases. As such, a warrant will appreciate in value the more it moves into-the-money.
Guide to Pay-off Profiles
| Pay-off profile of a Call Warrant at expiry |
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 |
| The x-axis represents the price evolution of the underlying security. As the security rises (falls) in price, you move along to the right (left) of the axis. |
| The y-axis represents the pay-off of the position. As the profit rises (falls), you move up (down) the axis. |
| The exercise price is the price at which the investor has the right to buy the underlying security. |
| The break-even point of the strategy corresponds to the underlying security price from which the strategy will generate a profit at expiry. It is equal to the exercise price plus the warrant price paid (multiplied by the conversion ratio, if applicable). |
| When compared to the long stock position (i.e. a direct investment in the underlying security), the call warrant position offers limited loss per underlying security and unlimited upside exposure. |
| Pay-off profile of a Put Warrant at expiry |
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 |
| The x-axis represents the price evolution of the underlying security. As the security rises (falls) in price, you move along to the right (left) of the axis. |
| The y-axis represents the pay-off of the position. As the profit rises (falls), you move up (down) the axis. |
| The exercise price is the price at which the investor has the right to buy the underlying security. |
| The break-even point of the strategy corresponds to the underlying security price from which the strategy will generate a profit at expiry. It is equal to the exercise price plus the warrant price paid (multiplied by the conversion ratio, if applicable). |
| When compared to the short stock position, the put warrant position offers limited loss per underlying security and significant upside exposure subject to the underlying security price falling to $0. |
Expiry and the passage of time
The expiry remains fixed during the life of the warrant. In general, the greater the period to expiry, the more expensive the warrant will be. However,with the passage of time, the level of probability that the warrant will finish in-the-money or more deeply so decreases and the value of the warrant decreases accordingly. The choice of expiry is therefore an important element in the investment decision-making process. However, the value of a longer-dated warrant will resist time decay better than a shorter-dated warrant,as shown in the graph below:
Volatility
Volatility is one of the most influential factors on a warrant's price, yet the hardest to understand. Defined simply, volatility is the measure of the price fluctuations of the underlying security. The historical volatility gives an indication of the way an underlying security behaved in the past and can be calculated by taking the annualised standard deviation of the return of the underlying security measured at regular intervals. However,when pricing a warrant, one must take into consideration the volatility anticipated by the financial markets for the life of the warrant, referred to as "implied volatility". Generally, for both calls and puts, the higher the implied volatility level, the more expensive the warrant.
In addition, implied volatility levels can move dramatically when sharp market corrections occur or in times of political instability,etc. Hence,the price of the warrant can vary even if the value of the underlying security remains unchanged as a result of the sensitivity of the warrant's price to changes in implied volatility levels.
In terms of risk, high volatility means a symmetrical risk (rise or fall) for the investor who has purchased the stock. However,for the warrant investor, the risk is limited on the downside to the premium paid while the upside exposure can be unlimited.
Dividends
The warrant price will be affected by changes in the market's expectations of the dividends due on the underlying instrument. In general,the higher the dividend yield expected, the lower the price of calls and the higher the price of puts.
Interest Rates
From a financial point of view, buying a warrant is comparable to buying (call warrant) or selling (put warrant) the underlying security on margin. As a result, a rise in interest rates will generally bring about a rise in the price of a call warrant and a drop in the price of a put warrant.
Conclusion
In order to make informed investment decisions, investors must have good understanding of how each parameter affects the price of the warrant on the secondary market. It should be kept in mind that warrants are liquid securities that can be easily bought and sold throughout the life of the warrant under normal market conditions. As a result, profits can be locked in prior to expiry by reselling the warrant. Impact of an increase in a given pricing parameter on a warrant's price.
| Call Price | Put Price | |
|---|---|---|
| Underlying Security Price Increases | Increases | Decreases |
| Time to Expiry Increases | Increases | Increases |
| Expected Dividend Yield Increases | Decreases | Increases |
| Interest Rate Increases | Increases | Decreases |
| Implied Volatility Increases | Increases | Increases |
Golden Rule: it's generally better to resell than to exercise a warrant
When investors exercise a warrant, they receive the intrinsic value of the warrant. Whereas,if they sell the warrant back, they receive the full value of the warrant, i.e. the intrinsic plus any time value. It is only at expiry when the time value is nil that both strategies offer the same return. In both cases, the investor will have to pay related transaction costs.
